False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas
Russell R. Wermers
Mutual Fund Per formance, False Discovery Rate, Multiple Testing.
This paper develops a simple technique that properly controls for “false discoveries,” or mutual funds that exhibit significant alphas by luck alone, to evaluate the performance of actively managed U.S. domestic-equity mutual funds during the 1975 to 2006 period. Our approach precisely separates mutual funds into those having (1) unskilled, (2) zeroalpha, and (3) skilled fund managers, net of expenses, even with cross-fund dependencies in estimated alphas. This separation into skill groups allows several new insights. First, we find that the majority of funds (75.4%) pick stocks well enough to cover their trading costs and other expenses, producing a zero alpha, consistent with the equilibrium model of Berk and Green (2004). Further, we find a significant proportion of skilled (positive alpha) funds prior to 1996, but almost none by 2006, accompanied by a large increase in unskilled (negative alpha) fund managers—due both to a large reduction in the proportion of fund managers with stockpicking skills and to a persistent level of expenses that exceed the value generated by these managers. Finally, we show that controlling for false discoveries substantially improves the ability to find funds with persistent performance.
Mutual Fund Performance, Multiple-Hypothesis Test, Luck, False Discovery Rate
Standard tests designed to identify mutual funds with non-zero alphas are problematic, in that they do not adequately account for the presence of lucky funds. Lucky funds have significant estimated alphas, while their true alphas are equal to zero. To address this issue, this paper quantifies the impact of luck with new measures built on the False Discovery Rate (FDR). These FDR measures provide a simple way to compute the proportion of funds with genuine positive or negative performance as well as their location in the cross-sectional alpha distribution. Using a large cross-section of U.S. domestic-equity funds, we find that about one fifth of the funds in the population truly yield negative alphas. These funds are dispersed in the left tail of the alpha distribution. We also find a small proportion of funds with truly positive performance, which are concentrated in the extreme right tail of the alpha distribution.
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